Tax Consequences of Selling Structured Settlement Payments

In most cases, selling the payments from your structured settlement incurs no tax liabilities. But state and federal laws outline some situations when taxes must be paid, and you should always consult a tax professional for information about your specific situation.

You have a structured settlement providing a reliable stream of payments, but you need a larger infusion of cash now. So you are considering selling some of your future payments and wondering if the Internal Revenue Service is going to take some of your cash from the sale.

The good news is that in most cases you won’t have to pay taxes on the proceeds from the sale of future structured settlements payments.

You will have to jump through some legal hoops, however. And there are some rare cases in which taxes will be due.

Taxation on Structured Settlement Sales

The general rule is if a structured settlement is not taxable, then selling the payments also is not taxable, as long as the contract provisions don’t change and the sale follows the law.

The law imposes several requirements on such sales, including oversight and approval by a judge.

When Are Structured Settlements Not Taxable?

The IRS and state governments are barred from taxing most structured settlement income — whether it’s paid all at once or in installments — under the federal Periodic Payment Settlement Act, which was passed in 1982 to ensure that structured settlements continued to provide financial security to those who received them.

The government views these payments as a way of keeping injured people from relying on public assistance, thereby benefiting American taxpayers, as well as the injured party. Structured settlement holders enjoy the benefit of not having to pay taxes on these payments.

The tax exclusion extends to interest and dividends earned by funds in structured settlement accounts.

Some Settlements Are Taxable

The U.S. Supreme Court ruled in 1995 that some proceeds from lawsuit settlements — for example, in cases involving lost wages for discrimination or emotional distress not caused by physical injury or illness — would be subject to income taxes.

Also, the IRS states that any compensation for punitive damages — the kind designed to punish the wrongdoer, rather than to assist the victim — is subject to taxes. This holds even if the punitive damages are part of a personal injury settlement.

PRO TIP

Taxable structured settlements are rare, and the payments are not often sold.

Although taxable structured settlements are rare, it’s best to confirm the status of your contract before attempting to sell your payments.

Personal Injury and Wrongful Death Settlements

In every case, any installment or lump-sum payments due to personal injury and wrongful death claims are exempt from federal, state and local taxes. That includes capital gains or any interest earned throughout the duration of installment payments.

Consequently, any sales of structured settlement payments in these types of cases also are tax exempt, as long as the sale follows all applicable law, including receiving the appropriate court approval.

Workers Compensation Settlements

Insurance companies can also issue annuity contracts to fund settlement payments in workers compensation cases that involve physical injuries or illnesses suffered in the workplace.

Section 104 (a)(2) of the Internal Revenue Code mandates that damages from on-the-job physical injuries or illnesses cannot be considered income, so they are not subject to taxation.

Additionally, settlement recipients can sell their future payments with the tax-free advantages in place, as allowed by Section 130 of the IRC.

Terrorism Law Applies Tax to Settlement Sales

In 2002, President George W. Bush signed the Victims of Terrorism Tax Relief Act of 2001 to provide relief to the victims of the Sept. 11 terrorism attacks.

At the same time, the Act essentially created a way for structured settlement holders to sell future payments — known as a factoring transaction. To protect sellers, the Act imposed a 40 percent excise tax on any profit from the purchase of most structured settlement payments.

Exceptions to the tax requirement exist. To qualify for an exception, purchasers have to follow specific rules, which include obtaining court approval. The rules are governed by state laws known as structured settlement protection acts.

Once a sale is approved by a court, the lump-sum payment is given the same tax treatment as the periodic payments. That means, in most instances, they are tax-free.

The intent of Congress and state lawmakers is to prevent factoring companies from taking advantage of settlement holders. Judges considering whether to approve sales of structured settlement payments must determine whether the sales are in the best interests of the people selling their payments.